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Appendix A

PRICING PRODUCTS AND


SERVICES

McGraw-Hill/Irwin Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Appendix A-2

Learning Objective 1

Compute the profit-


maximizing price of a product
or service using the price
elasticity of demands and
variable cost.
Appendix A-3
3

The Economists Approach to Pricing

Elasticity of Demand

The price elasticity of demand measures the degree


to which the unit sales of a product or service is
affected by a change in price.

Change Change
in versus in Unit
Price Sales
Appendix A-4
4

Price Elasticity of Demand


Demand for a product is inelastic if a
change in price has little effect on the
number of units sold.
Example
The demand for designer
perfumes sold at cosmetic
counters in department
stores is relatively inelastic.
Appendix A-5
5

Price Elasticity of Demand

Demand for a product is elastic if a


change in price has a substantial effect
on the number of units sold.
Example
The demand for gasoline is
relatively elastic because if a
gas station raises its price,
unit sales will drop as
customers seek lower prices
elsewhere.
Appendix A-6
6

Price Elasticity of Demand

As a manager, you should set higher


(lower) markups over cost when
demand is inelastic (elastic)
Appendix A-7
7

Price Elasticity of Demand

ln(1 + % change in quantity sold)


d =
ln(1 + % change in price)

Price elasticity of demand Natural log function


Appendix A-8
8

Price Elasticity of Demand


Suppose the managers of Natures Garden believe that
every 10 percent increase in the selling price of its apple-
almond shampoo will result in a 15 percent decrease in
the number of bottles of shampoo sold. Lets calculate the
price elasticity of demand.
For its strawberry glycerin soap, managers of Natures
Garden believe that the company will experience a 20
percent decrease in unit sales if its price is increased by
10 percent.
Appendix A-9
9

Price Elasticity of Demand


For Natures Garden apple-almond shampoo.
ln(1 + % change in quantity sold)
d =
ln(1 + % change in price)

ln(1 + (-0.15))
d =
ln(1 + (0.10))

ln(0.85)
d = = -1.71
ln(1.10)
Appendix A-10
10

Price Elasticity of Demand


For Natures Garden strawberry glycerin soap.
ln(1 + % change in quantity sold)
d =
ln(1 + % change in price)

ln(1 + (-0.20))
d =
ln(1 + (0.10))

ln(0.80)
d = = -2.34
ln(1.10)
Appendix A-11
11

Price Elasticity of Demand

The price elasticity of demand for the


strawberry glycerin soap is larger, in absolute
value, than the apple-almond shampoo. This
indicates that the demand for strawberry
glycerin soap is more elastic than the demand
for apple-almond shampoo.
Appendix A-12
12

The Profit-Maximizing Price


Under certain conditions, the profit-maximizing price
can be determined using the following formula:
Profit-maximizing -1
markup on =
1 + d
variable cost
Using the markup above is equivalent to setting the
selling price using the following formula:
-1
Profit- 1+
maximizing = 1 + d
price Variable cost per unit
Appendix A-13
13

The Profit-Maximizing Price


Lets determine the profit-maximizing price for the
apple-almond shampoo sold by Natures Garden.
The shampoo has a variable cost per unit of $2.00.
Price elasticity of demand = -1.71

Profit-maximizing -1.71
markup = - 1 = 1.41 or 141%
on variable cost -1.71 +1
Appendix A-14
14

The Profit-Maximizing Price


Now lets turn to the profit-maximizing price for the
strawberry glycerin soap sold by Natures Garden.
The soap has a variable cost per unit of $0.40.
Price elasticity of demand = -2.34

Profit-maximizing -2.34
markup = - 1 = 0.75 or 75%
on variable cost -2.34 +1
Appendix A-15
15

The Profit-Maximizing Price


The 75 percent markup for the strawberry
glycerin soap is lower than the 141 percent
markup for the apple-almond shampoo. This
is because the demand for strawberry glycerin
soap is more elastic than the demand for
apple-almond shampoo.
Appendix A-16

The Profit-Maximizing Price


This graph depicts how the profit-maximizing markup is
generally affected by how sensitive unit sales are to price.
Appendix A-17
17

The Profit-Maximizing Price

Natures Garden is currently selling 200,000 bars


of strawberry glycerin soap per year at the price
of $0.60 a bar. If the change in price has no effect
on the companys fixed costs or on other
products, lets determine the effect on contribution
margin of increasing the price by 10 percent.
Appendix A-18
18

The Profit-Maximizing Price


Contribution margin will increase by $1,600.
Appendix A-19

Learning Objective 2

Compute the selling price


of a product using the
absorption costing
approach.
Appendix A-20
20

The Absorption Costing Approach

Under the absorption approach to cost-plus


pricing, the cost base is the absorption
costing unit product cost rather than the
variable cost.
Appendix A-21
21

Setting a Target Selling Price


Here is information provided by the management of
Ritter Company.

Assuming Ritter will produce and sell 10,000


units of the new product, and that Ritter typically
uses a 50% markup percentage, lets determine
the unit product cost.
Appendix A-22
22

Setting a Target Selling Price


The first step in the absorption costing approach to
cost-plus pricing is to compute the unit product cost.

Ritter has a policy of marking up unit product costs


by 50%. Lets calculate the target selling price.
Appendix A-23
23

Setting a Target Selling Price


The second step is to calculate the target selling
price ($30) by assigning the appropriate markup
($10) to the unit product cost ($20).
Appendix A-24
24

Determining the Markup Percentage


A markup percentage can be based on an industry rule
of thumb, company tradition, or it can be explicitly
calculated.
The equation for calculating the markup percentage on
absorption cost is shown below.

Markup %
(Required ROI Investment) + S & A expenses
on absorption = Unit sales Unit product cost
cost

The markup must be high enough to cover S & A


expenses and to provide an adequate return on
investment.
Appendix A-25
25

Determining the Markup Percentage

Lets
Lets assume
assume that
that Ritter
Ritter must
must invest
invest $100,000
$100,000 in
in the
the
product
product and
and market
market 10,000
10,000 units
units of
of product
product each
each
year.
year. The
The company
company requires
requires aa 20
20 percent
percent ROI
ROI on
on all
all
investments.
investments. Lets
Lets determine
determine Ritters
Ritters markup
markup
percentage
percentage onon absorption
absorption cost.
cost.
Appendix A-26
26

Determining the Markup Percentage

Markup %
on absorption = (20% $100,000) + ($2 10,000 + $60,000)
cost 10,000 $20
Variable SG&A per unit Total fixed SG&A

Markup %
($20,000 + $80,000)
on absorption = $200,000 = 50%
cost
Appendix A-27
27

Problems with the Absorption Costing


Approach
The absorption costing approach assumes that
customers need the forecasted unit sales and will
pay whatever price the company decides to
charge. This is flawed logic simply because
customers have a choice.
Appendix A-28
28

Problems with the Absorption Costing


Approach
Lets assume that Ritter sells only 7,000 units at
$30 per unit, instead of the forecasted 10,000
units. Here is the income statement.
Appendix A-29
29

Problems with the Absorption Costing


Approach
Lets assume that Ritter sells only 7,000 units at
$30 per unit, instead of the forecasted 10,000
units. Here is the income statement.

Absorption
Absorption costing
costing approach
approach to
to pricing
pricing is
is aa safe
safe
approach
approach only
only ifif customers
customers choose
choose toto buy
buy atat
least
least as
as many
many units
units asas managers
managers forecasted
forecasted
they
they would
would buy.
buy.
Appendix A-30

Learning Objective 3

Compute the target


cost for a new product
or service.
Appendix A-31
31

Target Costing
Target costing is the process of determining the
maximum allowable cost for a new product and then
developing a prototype that can be made for that
maximum target cost figure. The equation for
determining a target price is shown below:

Target
Target cost
cost == Anticipated
Anticipated selling
selling price
price Desired
Desired profit
profit
Once the target cost is determined, the
product development team is given the
responsibility of designing the product
so that it can be made for no more than
the target cost.
Appendix A-32
32

Reasons for Using Target Costing

Two characteristics of prices and product costs:


1. The market (i.e., supply and demand)
determines price.
2. Most of the cost of a product is determined
in the design stage.
Appendix A-33
33

Reasons for Using Target Costing

Target
Target costing
costing was
was developed
developed in
in recognition
recognition
of
of the
the two
two characteristics
characteristics summarized
summarized onon
the
the previous
previous screen.
screen.
Target
Target costing
costing begins
begins the
the product
product development
development
process
process by
by recognizing
recognizing and
and responding
responding to
to
existing
existing market
market prices.
prices. Other
Other approaches
approaches
allow
allow engineers
engineers to
to design
design products
products without
without
considering
considering market
market prices.
prices.
Appendix A-34
34

Reasons for Using Target Costing


Target costing focuses a companys cost reduction
efforts in the product design stage of production.
Other approaches attempt to squeeze costs out of
the manufacturing process after they come to
the realization that the cost of a manufactured
product does not bear a profitable relationship to
the existing market price.
Appendix A-35
35

Target Costing
Handy Appliance feels there is a niche for a
hand mixer with certain features. The
Marketing Department believes that a price of
$30 would be about right and that about
40,000 mixers could be sold. An investment of
$2,000,000 is required to gear up for
production. The company requires a 15
percent ROI on invested funds.
Let see how we determine the target cost.
Appendix A-36
36

Target Costing

Each functional area within Handy Appliance


would be responsible for keeping its actual costs
within the target established for that area.
Appendix A-37
37

End of Appendix A